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Settling Injury to Feelings: A Taxing Time
Until recently, you could be forgiven for thinking that sums paid as settlement for injury to feelings were tax exempt. That forgiveness stops here: the Upper Tribunal (“UKUT”) has confirmed that payments for injury to feelings do not fall within the tax exemption which applies to payments for “injury” (under s.406 ITEPA). This means there are conflicting decisions in respect to this issue in two different forums: The EAT and UKUT. In this article, I explore the UKUT’s judgment and consider how to advise clients correctly.
Mr Moorthy was dismissed for redundancy, paid statutory redundancy pay of £10,640 (from which no tax was deducted) and subsequently brought a claim in the Employment Tribunal (“ET”) for unfair dismissal and age discrimination. An agreement was reached to settle the claim for £200,000.
When Mr Moorthy filed his tax return, he claimed that the full £200,000 settlement was exempt from tax. HMRC disagreed and ultimately issued a closure notice agreeing to reduce the tax liability by £30,000 under s.403 ITEPA (for termination payments) then by a further £30,000 as a concession, reluctantly accepting that this could reflect damages for injury to feelings at the top Vento range. The matter progressed to the First-Tier Tribunal (“FTT”) which found that:
- the settlement amount of £200,000 fell to be taxed as income under section 401 ITEPA;
- the £30,000 exemption allowed by section 403 ITEPA was reduced by the £10,640 which had already been paid (tax free) as statutory redundancy; and
- the statutory exemption in respect of an “injury” under s.406 ITEPA does not cover injury to feelings awards, and the EAT in Orthet Limited v Vince-Cain  ICR 324 was wrong.
Mr Moorthy appealed to the UKUT.
What did the Upper Tribunal decide?
The UKUT found that the scope of section 401 is wide: It includes non-pecuniary awards such as damages for injury to feelings if they are connected with the termination of employment. It also includes payments where the termination of employment was entirely fair and lawful. It rejected Oti-Obihara  UKFTT 568 (TC), concluding that it had been wrongly decided and should not be followed.
The UKUT held that the only question that determines whether section 401 ITEPA applies to an award is whether the payment was "directly or indirectly in consideration or in consequence of, or otherwise in connection with, the termination of a person’s employment”. A desire to settle a claim or to protect an employer’s reputation is irrelevant to the question: Once the necessary connection between the payment and the termination is established, an award falls within section 401.
It was further held that the term “injury” in section 406 ITEPA refers to a medical condition and does not include injury to feelings. The UKUT thereby followed Horner  S.T.C. 766 and held that Orthet and Timothy James  ICR 764 were wrongly decided.
Practitioners advising respondents or claimants should keep two key things in mind following the UKUT’s decision in Moorthy:
- settlement sums paid in respect of injury to feelings that are “directly or indirectly in consideration or in consequence of, or otherwise in connection with, the termination of a person’s employment” fall to be taxed as income (after the £30,000 threshold);
- sums for injury to feelings referable to acts / claims which are separate from and occurred independently of termination should still be tax free (see Walker v Adams (HM Inspector of Taxes) 2002 SpC 344); and
- section 406 ITEPA applies to settlement sums paid as compensation for an injury which constitutes an actual medical condition, but not to injury to feelings.
It might be tempting for employment practitioners to want to stick to the familiarity of the EAT decisions (which suggest injury to feelings awards are always tax exempt) rather than delving into the unchartered waters of tax tribunal decisions. However, ultimately, it is not the EAT but the tax tribunals that have jurisdiction to determine whether a client is liable to pay tax on a settlement award. In short, ignore Moorthy at your peril.
For employer clients, this means that HMRC may come knocking for extra sums if a settlement was paid tax free, since it is the liability of the employer to pay tax on employment income. Hence, it is advisable to deduct tax at source (and the employee can seek to reclaim any tax themselves, in discussion with HMRC) or if the employer chooses to pay sums free of tax, a tightly-worded tax indemnity will be the next best safety net.
For employee clients, do not be surprised if the employer insists on deducting tax at source. However, even if the employer agrees to pay the sum tax free (but with indemnities) be mindful that the employee may ultimately have to pay the tax due.